Financialization and Institutional Change in Capitalisms: A Comparison of the US and Germany

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The Journal of Comparative Economic Studies, Vol.9, 2014, pp Financialization and Institutional Change in Capitalisms: A Comparison of the US and Germany Richard DEEG * * Temple University, USA;
The Journal of Comparative Economic Studies, Vol.9, 2014, pp Financialization and Institutional Change in Capitalisms: A Comparison of the US and Germany Richard DEEG * * Temple University, USA; Abstract: This paper analyzes and compares the process of financialization and itsconsequences for political economic institutions in the United States and Germany. It advances the argument that the best way to explain institutional change and cross-national diversity is through an actor-centered institutional approach that recognizes how actors innovate within institutional and structural constraints to new pressures for change. It is argued that the high degree of financialization and market liberalization of the US economy was not pre-determined by structural forces or American culture, but a combined product of structural forces, institutional features of policymaking, and political choices. In Germany there is much less financialization than in the US, but it still led to institutional changes that opened up more space for some firms to construct firm-level institutional complementarities that deviate from the traditional German economic model. This supports a more general conclusion that, under conditions of financialization and globalization, national-level institutional complementarities may be waning in advanced economies, giving way to greater internal diversity and a proliferation of divergent firm and sectoral-level institutional complementarities. Keywords: financialization, US, Germany, varieties of capitalism JEL Classification Numbers: P50, L50, J50, G38 1. Introduction The process of financialization has become a central object of study by political economy scholars. In general terms, financialization refers to the growing influence of financial actors (whether direct or mediated via markets) over the real economy (i.e., control financialization) and the growing portion of corporate revenue and profits deriving from financial transactions (i.e., profit financialization). This process is evident across the OECD economies, with a systematic growth in financialization generally beginning in the 1980s (Epstein and Jayadev 2006; Krippner 2005; Davis 2009). Financialization is both a product and cause of broader market liberalization processes encompassing product, service, and labor markets that spread across the advanced economies over the last thirty years. As such, examining financialization focuses attention one of the key (if not the main) causal mechanisms of institutional change in advanced economies and is essential to any account of institutional change in national political economies. It appears the 48 R. DEEG recent global financial only slowed the financialization processes, and there is little reason to think that the profound expansion of financial market influence over capitalism will be dramatically rolled back. For much of the last twenty years, financialization was seen as the key driver in the erosion of distinct varieties of capitalism and convergence on a largely liberal model of capitalism, including its focus on shareholder value as the dominant norm for corporate management (Lazonick and O Sullivan 2001). It is argued that increasingly mobile capital demanded deregulation of financial activity and fostered convergence in corporate governance arrangements that would facilitate cross-border investment flows. Even those who did not believe the convergence thesis viewed financialization as a monolithic and irresistible force of liberalization that eroded non-market coordination mechanisms among firms and between capital and labor. However, it is now clear that, while financialization is an ubiquitous process in the advanced economies, the degree and consequences of financialization are quite varied (e.g., Engelen at al 2008; Wood and Wright 2010). And though there has certainly been notable cross-national convergence in financial market structures and corporate governance regulations, it is not clear that national models have, on the whole, become more similar. Moreover, the impact of financialization within different national economies varies considerably. Convergence and mainstream economic theories would predict comparable rates, or at least converging rates, of financialization in both cases examined in this article. Some convergence theories see isomorphic pressures toward shareholder value ideology as a key driver, while others emphasize the role of global financial actors, especially institutional investors, as agents of change. Yet another group emphasizes the application of hegemonic power by the US (with some aid from the UK) in promoting an Anglo-American model of finance that favors American and British financial institutions in global markets. Regardless of which causal pathway is emphasized, all convergence theories predict that national economies will converge toward the Anglo model, even as that Anglo model itself becomes more financialized. In contrast, Varieties of Capitalism (VoC) theory predicts relatively limited financialization of coordinated market economies and thus limited convergence between them and liberal market economies (LME). This prediction is rooted in the argument that economic actors (chiefly firms) would resist extensive liberalization and financialization because of their material and strategic interest in maintaining a system of patient capital that facilitates firm strategies based on investment in specific assets firm and industry-specific labor skills, joint R&D, joint production and relational contracting. Because specific assets are not easily turned to new purposes, firms need reliable sources of investment capital that will support them through temporary downturns in demand. That said, Hall and Soskice (2001) did note that if CMEs were to converge on LMEs, it would be through the power of financial actors who would drive a market logic and market coordination Financialization and Institutional Change in Capitalisms 49 mechanisms into other institutional domains through the institutional complementarities that link the different domains of the economy. In the case of LMEs, such as the UK, VoC expected that financialization would strengthen market coordination (and competition) in all institutional domains and for all size firms. One can also identify a third perspective on financialization that emphasizes three structural variables as the key determinants of the degree of financialization. The first structural variable is the availability of sufficient amount of mobile capital (i.e., deep and liquid capital markets); the second is the presence of sufficient number of large and influential shareholder value-oriented investors (i.e., a large funded pension system or functional equivalents); and finally, adequate managerial discretion over the extent and direction of factor mobility, including capital and labor (i.e., deregulated product and labor markets; See Engelen et al 2008; Morgan and Kubo 2005). This paper advances the argument that the best way to explain the extent and pattern of institutional change, as well as cross-national diversity, is through an actor-centered institutional approach that recognizes how actors innovate within institutional and structural constraints to new pressures for change 1. The extent of innovation or institutional change, and thus the degree of financialization and cross-national convergence, is also constrained at the macro level by the dominant domestic political coalition. The contrasting cases of the US and Germany show extensive financialization and liberalization in both, but also substantial differences in the degree and pattern of change. To some extent this is not surprising from the perspective of institutional theory, which predicts gradual, path dependent change. However, this leaves open the question of explaining specific instances of institutional changes that do not conform to common predictions: Stated more specifically, the paper will argue that the high degree of financialization of the US economy was not pre-determined by structural forces, but a combined product of structural forces, institutional features, and political choices. A similar theoretical frame is applied to Germany which, although it did not financialize or liberalize as much as the US and other advanced economies, exhibits a greater degree of these in some respects than many would have predicted. The case of Germany also illustrates well a common pattern in many advanced economies; namely, that institutional changes adopted by governments have opened up more space for firms especially large, but even small firms to choose their own firm-level institutions, i.e., to construct a diverse set of firm-level institutional complementarities. Thus some firms in Germany have chosen a more shareholder-oriented approach and increased their use of contingent labor, while others hew more closely to the traditional stakeholder model. This supports a more general conclusion that national-level institutional complementarities may be waning in advanced economies, giving way to greater cross-national and internal diversity and a proliferation of divergent firm and sectoral-level institutional complementarities (e.g., Deeg and Jackson, 2007; Woods and Lane, 2012). 50 R. DEEG 2. Financialization and institutional change in the US model of capitalism From the late 1930s to 1970s the US model of capitalism was based loosely on a Keynesian growth model. The state pursued policies to simulate and maintain aggregate demand and promoted core sectors of the economy such as housing and infrastructure construction. Collective bargaining and pro-labor policies were widely accepted in the public and corporate spheres, while bargaining agreements influenced wages and working conditions across much of the economy. Product market regulation including financial was fairly extensive. After WWII, promoting the expansion of global trade was a tenet of the American growth strategy. Industrial policy in the US was more covert than in other advanced economies, but extensive in certain sectors, especially those related to defense (Vogel 1996). Politically, this era was dominated by the Democratic New Deal coalition the urban working class, southerners, farmers, and much of the middle class. The American manufacturing sector was dominated by Fordism and large, vertically-integrated firms. The Fordist model relied on unskilled and semi-skilled workers, and was thus compatible with a general skills-based training system (Thelen 2007). It was complemented by weak forms of stakeholder corporate governance and an acceptance of unionized labor, made possible in part by regulated product markets, US global economic dominance, and a relatively high degree of managerial autonomy and thus relative indifference to financial market demands arising from the generally dispersed and passive nature of corporate ownership (Davis 2009). It was also during this era that corporate provision of welfare in the form of health insurance and defined benefit pensions came to be the norm, made by possible by tax incentives and relatively muted market and financial pressures on corporate managers. One could readily argue that several institutional complementarities marked this model. One would be that weak stakeholder governance and unionization (de-commodified labor) were complementary to regulated markets and the demand-led growth model. In retrospect, though, some of the institutional complementarities in the US model may not have been that strong, since their maintenance depended as much on political factors (voluntary compliance more than legal requirement) as on economic efficiency gains. With the onset of product market deregulation in the late 1970s, the competitiveness problems of US industry in that same decade, the decline of the supporting New Deal coalition (due in good part to the defection of southern Democrats from the party), shifts in technology and other structural economic conditions, a rapid shift occurred in preferences of employers regarding labor relations and finance/corporate governance during 1980s (Deeg 2012b). During the 1980s US corporate governance shifted from a system of managerial dominance with a weak norm of stakeholder governance to a system of shareholder value governance (O Sullivan 2009). External financial actors gained greater influence over corporate managers Financialization and Institutional Change in Capitalisms 51 via takeover activity, use of performance pay, and shareholder activism (driven in part by the rise of institutional investors). The shift cannot be attributed to any single, major reform. Rather, it was more a result of the new leveraged buyout wave and pressure from activist buyout funds; this was facilitated further by regulatory and tax rulings favoring the use of stock options for executive compensation (Davis 2009; O Sullivan 2009). Whether incidental or intentional, the complement to this shift in corporate governance was a corporate assault on organized labor. From the early 1950s to the early 1970s, the unionization rate in the US hovered around 30 percent of the labor force. The rate began declining during the 1970s and accelerated rapidly during the 1980s (it now stands at roughly 12% overall and 7% in the private sector: Lehne 2005; Godard 2009). The extent of union decline in the US is unique among advanced economies and cannot be linked to major formal institutional reforms. Rather the attack on unions and their decline was possible because the preceding period of relatively peaceful cooperation between management and labor rested to a considerable degree on management s voluntary acceptance of organized labor representation. The decline, then, occurred to a great degree through anti-labor interpretations and enforcement of existing labor laws and regulations by the President, federal bureaucracy and courts. These changes in labor and corporate governance institutions were facilitated politically by President Reagan s anti-government movement (Prasad 2006, 67-70): Deregulation, a smaller state, and freer markets were touted as the solution to the economic ills of the 1970s and early 1980s. By the early 1990s, the US model had coalesced around a new model based on a different set of complementarities: deregulated and decentralized labor markets combined with shareholder-oriented finance and corporate governance to produce a system with a highly flexible allocation of productive resources regarded within the US and by VoC theory as a chief competitive advantage of a liberal market economy (LME). Today there are few statutory or normative restrictions on layoffs by employers and the US has the most flexible labor force in the OECD 2. Labor and wage flexibility are further enhanced by the comparatively low replacement rate and duration for unemployment insurance. The American model was also no longer organized by and around large integrated firms, but by markets guided by financial imperatives (also Davis 2009). But how do we explain this pattern of change, and what role did institutional complementarities play in shaping it? From a theoretical perspective, the evolution of US capitalism over the last three decades accords well with the Varieties of Capitalism (VoC) prediction that inherently liberal market economies (LMEs) will, under increased competitive pressures, become even more liberal (i.e. market oriented) in their economic governance (Hall and Soskice 2001). Yet this theory gives us little to explain or predict the degree to which an LME will liberalize, nor does it help us understand why the US economy so heavily financialized, i.e. dependent on finance-driven activity for economic growth. It also does not help us understand why the US 52 R. DEEG model came to rely increasingly on excess leverage by banks and especially consumers as its source of growth. There are a variety of structural theories that explain liberalization and financialization in the US, but this paper will argue that structural factors alone are insufficient. Rather, answering these questions requires a historical examination that also incorporates the role of US-specific institutions and the political coalitions that emerged to reshape the rules defining the US model. The central feature of change in American capitalism is without doubt the financialization of its economy. First, the financial sector expanded as a portion of the economy from 1975 to 2004 total stock and bond market capitalization grew from 102% to 289% of GDP (Deeg 2010, 316); the portion of corporate profits accruing to financial firms and to financial transactions of non-financial firms rose dramatically from around 10% in the early 1980s to 40% in the early 2000s (Krippner, 2005, 2011); the influence of financial firms over corporate management decisions expanded through the rise of shareholder value principles (Perry and Nölke 2005); institutional investors and nonbank financial institutions ( shadow banking ) became major pillars of the industry; the financial behavior of households also changed dramatically, as pension funds and mutual funds became the central vehicle for saving and investment (Langley 2008; Davis 2009). While VoC theory offers a economic functionalist explanation of the financialization of the US economy, other theories offer political functionalist explanations. Krippner (2011), for example, argues that the US was confronted by three crises as economic growth slowed during the 1970s; a social crisis of heightened distributional conflicts; a fiscal crisis as the growing cost of social benefits increasingly outstripped revenue to pay for them; and a legitimation crisis for the state, given its inability to handle the first two crises, leading to a loss of trust in government. The state s ad hoc responses to these crisis led to three interrelated policy shifts that created a macro environment conducive to financialization: First, deregulation of financial markets in 1970s; second, increasing dependence/reliance on foreign capital to finance deficits (starting in 1980s); and third, a radical change in monetary policy. These policy shifts led to a credit boom that stimulated more consumption and investment while increasing foreign capital flows to finance US deficits. The expansion of private consumption and the resulting growth allowed the US government to reduce conflicts over finite state resources. Thus, a self-reinforcing political dynamic of financialization ensued. Schwartz (2009) argues that the creation and growth of a residential mortgage-backed securities (RMBS) market in the 1990s, a product of both private sector initiative and government policy, boosted investor demand for mortgages, in turn driving down interest rates and allowing consumers to borrow against their home equity in order to increase consumption. Simultaneously, global disinflation made US-originated RMBS an attractive investment for global capital which helped finance the rising US current account deficit. Together these Financialization and Institutional Change in Capitalisms 53 produced a strong demand stimulus during the long 1990s ( ) and high economic growth rates. The comparatively high growth of the US economy boosted overseas investment by US multinationals and purchases of financial assets abroad by banks. Thus, like Krippner, he sees the financialization dynamic as driven in large part by the unintended outcomes of policy choices and structural changes that yielded superior economic results, which, in turn, reinforced policymakers belief that the US model of financial capitalism was a superior and durable model. These structural theories do highlight important contributors to financialization in the US, perhaps most importantly the role of positive feedback effects between economic growth based on demand/credit expansion and subsequent policy choices. Schwartz also highligh
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